“Risk comes from not knowing what you’re doing.” – Warren Buffett
Whether we’re motivated by fear or potential rewards, humans are wired to react based on our emotions. Due to this reality, our decision-making process is often subject to biases.
For instance, rather than carefully weighing the future pros and cons of a choice, our minds tend to only focus on the worst-case scenario, and we plan based on that outcome, no matter how unlikely it is to occur.
We can largely thank what’s known as the “neglect of probability bias” for our propensity to overlook the odds. Look no further than one well-known study, where one group of participants was told that an unpleasant event (like a sudden loud noise) was going to occur in the near-future. The second group, on the other hand, was told there was a specific probability that the unpleasant event might occur. No matter how much the probability was lowered for the second group (eventually, all the way down to 5%), they still had the same levels of anxiety about the event occurring, and they made decisions accordingly.
Probability neglect makes us feel like we are wisely preparing ourselves for potential dangers, but solely focusing on your biggest fears can greatly distort your perspective.
Investors are also prone to fall for this trap, and the results can be very costly. In the world of investing, this mental glitch can make you see the stock market as a way to lose wealth rather than a way to build wealth.
For example, the 2007-2009 stock market declines (where the S&P 500 – a major benchmark for the US stock market – lost 56% of its value from peak to trough), still warp many investors’ perspectives to this day. Akin to the aforementioned study, investors’ minds will often drift to this worst-case scenario whenever there’s a market downturn.
However, focusing on this crash while making an emotional investment decision not only ignores the fact that it was a rare occurrence, but it also neglects the probability of the market’s recovery from such events. No matter what cataclysmic event has occurred, the market has not only always recovered, but it has also gone on to reach record-breaking highs. In fact, over a 20-year rolling time span, the S&P 500 has never failed to generate positive overall returns.
Focusing solely on possibility – while ignoring probability – can lead to you missing strong returns in the market during recoveries, while also selling your investments during declines. Simply put, you’ll end up buying high and selling low, which is the opposite of successful investing behavior.
Wise investors know that the biggest threat to their long-term investment objectives isn’t the markets themselves; it’s their emotions. The other, more difficult part is sticking to a long-term plan when your instincts are screaming at you to do otherwise.
Want to learn more about our disciplined approach to investing? Contact LexION Capital today to start a conversation.